Capstead Mortgage Corporation (NYSE:CMO) – Prepayment Speeds and Rising Interest Rates Signals ‘RED’ for REITs – AGNC, HTS

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Dallas, Texas 09/11/2013 (Financialstrend) – A real estate investment trust (REIT), Capstead Mortgage Corporation (NYSE:CMO) invests in a portfolio of residential mortgage pass-through securities. This mainly includes adjustable-rate mortgage (ARM) securities issued and guaranteed by an agency of the federal government or by government-sponsored enterprises. Such guarantees include Federal National Mortgage Association (Fannie Mae) or Federal Home Loan Mortgage Corporation (Freddie Mac) or Government National Mortgage Association (Ginnie Mae).

As the rising interest rates impair the yield of mortgage backed security holdings, mortgage REITs like CMO, American Capital Agency Corp. (NASDAQ:AGNC), Annaly Capital Management, Inc. (NYSE:NLY), Hatteras Financial Corp. (NYSE:HTS) and MFA Financial, Inc. (NYSE:MFA) have already posted big dips in their book value per share.

With the bond market being in a quiet mode, the Refinance Index dropped to 2.3% last week. A drop in refinance-applications shared to 63% is largely driven by consensus sentiment of purchase-driven market. The drop in interest rates coupled with prepayment speeds of mortgage REITS influenced by provision for early repayment of mortgages without any penalty is the catastrophic blow for mortgage REITS such as CMO as well as other players like NLY and AGNC.

Rise in prepayment speeds adversely affect the mortgage REITs as the investor like CMO loses out on high yielding asset and are forced to reinvest the proceeds into low-yield investment which in turn bust the returns. Given the volatility in the interest-rate environment, these REITs have to better hedge their investments to combat the rise in rates alongside the prepayment worries.

However given the strategic management decisions aiding to expense reductions and timely moves to reduce exposure to hard-hitting segment of mortgage-related securities have resulted in just over 2% decline to its book value in the second quarter. Though CMO has efficiently absorbed the shocks during the period of Great Recession and credit crunch, the present risk to the dividend given the management outlook of portfolio stability over growth besides speculative volatility in economic environment is of concern.

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